Inside the payroll tax holiday and how to have a happy one

The Bush tax cut deal includes a payroll tax holiday that gives most working Americans a 2 percent raise. Lawmakers view the payroll tax holiday as an economic stimulus on the assumption that people will spend that extra money. But some economists say that consumers will probably save more of that money than the politicians hope.

Payroll tax holiday: economic stimulus?

The payroll tax holiday proposal rolls back the employees’ share of the payroll tax from 6.2 percent to 4.2 percent on income up to $106,000. When the tax deal was announced, firms like Deutche Bank revised their economic growth predictions for 2011 from 3.3 percent to 4.1 percent. Here’s the math behind that reasoning:

Wages and salaries in the U.S. in 2010 total $6.44 trillion. That figure grew nearly 5 percent in the second and third quarter. If that rate continues, wages and salaries will total about $6.75 trillion a year from now. Deutche Bank estimates about 85 percent of total wages and salaries are dinged by the payroll tax. A 2 percent reduction in that tax puts $115 billion back in workers’ wallets. Based on the current personal savings rate of 5.8 percent, $108 billion — 0.7 percent of estimated 2011 GDP — would be spent. Therefore, 3.3 + 0.7 = 4.1 percent.

The reality of the Permanent Income Hypothesis

Some believe Deutche Bank is overly optimistic. John Carney at CNBC writes that the payroll tax holiday won’t increase spending nearly that much because informed consumers will realize their 2 percent raise is only temporary. Economists call this the Permanent Income Hypothesis. People spend based on expectations of future income, not current take-home pay. Before the financial crisis and its aftermath, most people spent more than they earned and didn’t save a dime. Then the bottom fell out. Now people spend less and save more because expectations for the future are diminished.

How to use your payroll tax holiday

What do do with that payroll tax holiday raise? If you don’t run out and spend it, SmartMoney suggests putting that 2 percent raise into a 401(k), a traditional IRA or a Roth IRA. That will make those after-tax dollars worth more than when the payroll tax holiday ends in 2012. Health care costs are expected to go up next year, so saving now to cover those increases is an option. Another suggestion is to spend it — on new appliances that can save hundreds of dollars on energy in the coming years.